Many of Berkshire’s businesses have an extraordinary performance that may not be immediately obvious to the untrained observer. Certainly, if you compare the earnings history of Buffalo News or Scott Fetzer to their publicly-owned counterparts, they might be similar.

The reality behind the scenes is that most public companies retain at least two-thirds or more of their earnings to fund their growth. On the other hand, Berkshire subsidiaries have always returned 100% of their earnings to their parent company.

At Berkshire, reported earnings are a poor measure of the economic performance because the numbers represent only the dividends received from investees (which is a small fraction of the earnings attributable to their ownership).

Instead, the concept of “look-through” earnings is used. This consists of:

1) The reported operating earnings, plus;
2) Berkshire’s share of the retained earnings of major investees that are not reflected in their profits under GAAP, less;
3) An allowance for tax that would be paid by Berkshire if these retained earnings have been distributed.

The letters of Warren Buffett are written one year apart. Sometimes, he will repeat certain points a few times in different years. This helps to remind existing shareholders as well as teach new shareholders his ideas.

On the other hand, my blog is more like Buffettology condensed. I take about two weeks to summarise each of his letter. So sometimes, in less than a month of so, you might read about the same topic twice.

After starting on this journey from 1977, I’m now at 1994 and closing in onto 2007. Hope to get there soon!

Look Through Earnings

Look-through earnings is used to more accurately portray Berkshire’s earnings. It consists of:

(1) the operating earnings, plus; (2) the retained operating earnings of major investees that, under GAAP accounting, are not reflected in Berkshire’s profits, less; (3) an allowance for the tax that would be paid by Berkshire if these retained earnings of investees had instead been distributed to us.

The “operating earnings” that is mentioned here exclude capital gains, special accounting items and major restructuring charges.

For the intrinsic value of Berkshire to grow at 15%, their look-through earnings must also increase at about that pace.

Note that the “operating earnings” which is referred to exclude capital gains, special accounting items and major restructuring charges.

Over time, Berkshire’s look-through earnings need to increase at about 15% annually for their intrinsic value to grow at that rate. In the previous year’s letter, Buffett had explained that to meet the 15% goal, these earnings will have to increase to $1.8 billion in the year 2000. Because of the issuance of additional shares in 1993, the amount required has now risen to $1.85 billion.

One managerial practice that Buffett has criticized in the past is that of shooting the arrow of performance and then painting the target. Buffett makes himself accountable to shareholders and boldly paints his target (of 15% goal) first. However, for the target to be achieved, he will need markets that allow the purchase of businesses on sensible terms. If prices are high, there is no need to do something just because there is excess cash.

Over time, Buffett expects the look through earnings to be a conservative estimate of Berkshire’s true economic strength.

For example, in 1986 they bought 3 million shares of Capital Cities/ABC for $172.50/share. When 1/3 of the stake was sold years in 1993, there was a realized profit of $297 after deducting a 35% capital gains tax. If the look through earnings of Cap Cities during those 8 years were distributed to Berkshire after deducting a tax of 14% (this is the tax rate that Berkshire pays for dividends), it would be only $152 million in gains.

For the 3rd year in a row, Warren Buffett talks about the concept of look through earnings. As explained by Warren, look through earnings consists of:

(1) the reported operating earnings, plus; (2) the retained operating earnings of major investees that, under GAAP accounting, are not reflected in our profits, less; (3) an allowance for the tax that would be paid by Berkshire if these retained earnings of investees had instead been distributed to us.

Warren believed that the look-through number more accurately portrays the earnings of Berkshire than the GAAP number.

For Berkshire’s intrinsic value to grow at 15% annually, the look through earnings also has to grow at that rate.

This means that not only does Berkshire’s operating subsidiaries and investees have to deliver excellent operating results, the skill of capital allocation will also be very important as well.

When capital is allocated today, it is with the thought of how that allocation will maximize look through earnings many years in the future.

However, this long-term focus does not eliminating the need for Berkshire to achieve decent short-term performance. After all, today’s performance is also the result of “long term” thinking made many years ago.

If a company fails to deliver for extended periods of time and blames it for their long time focus, then there is reason to be suspicious of their management.

Similarly, you should be suspicious of managers who increase their short-term earnings using tricks like accounting maneuvers, asset sales, etc.

(1) the reported operating earnings, plus ;
(2) the retained operating earnings of major investees that, under GAAP accounting, are not reflected in the profits, minus;
(3) an allowance for the tax that would be paid if these retained earnings of investees had instead been distributed.

Investors can also benefit by focusing on their own look-through earnings. This can be calculated by looking at the total underlying earnings attributable to the shares that you hold in your portfolio.

Your role should then be to create a portfolio (or “company”) that will produce the highest look through earnings a long time from now.

Using this approach will force you to look at the long term business prospects rather than the short term market movements. Future earnings will, at the end of the day, influence the prices.

“In investing, just as in baseball, to put runs on the scoreboard one must watch the playing field, not the scoreboard.”

It has been a while since my last post. The blog has shifted over to blogger beta and one cool feature that has been added is the use of labels.

By clicking on the labels at the end of each post, you will be able to see posts sorted by specific labels (categories). This is an improvement on the previous limited nagivation style of blogger.

Part 1 of Warren Buffett’s 1990 letter follows. You will notice that it is very short. This is because I have decided to move to shorter (and more frequent) postings. Figured this is what most readers want.

Look Through Earnings

Looking at the reported earnings of a company can be misleading. Accounting numbers should be used as a beginning, not an end, to calculate the true “economic earnings” of the company.

For example, Berkshire has huge investments in companies whose earnings far exceed their dividends that is reported in Berkshire’s accounts. An extreme case is Capital Cities/ABC, Inc, where Berkshire’s 17% share of the company’s earnings amounted to more than $83 million in 1989, yet only about $530,000 was counted in Berkshire’s GAAP earnings.

$82 million-plus stayed with Cap Cities as retained earnings, which will ultimately work for Berkshire’s benefits but in the meantime go unrecorded on their books.

A good way to look at the real earnings of a company is to include the share of the operating earnings retained by the company’s investees, deduct the estimated tax and then add it to the reported earnings.

If the base from which the growth is measured is small, it may still last a long time. But once it becomes big, it will eventually stop.

This phenomenal is aptly described by Carl Sagan, refering to the destiny of bacteria that reproduce by dividing into two every 15 minutes. Says Sagan:

“That means four doublings an hour, and 96 doublings a day. Although a bacterium weighs only about a trillionth of a gram, its descendants, after a day of wild asexual abandon, will collectively weigh as much as a mountain…in two days, more than the sun – and before very long, everything in the universe will be made of bacteria.”

Not to worry, says Sagan: Some obstacle always impedes this kind of exponential growth. “The bugs run out of food, or they poison each other, or they are shy about reproducing in public.”

From Berkshire’s base of $4.9 billion in net worth, it will be much more difficult to average 15% annual growth in book value than they did to average 23.8% from the $22 million they began with.

Taxes

A new accounting rule likely to be adopted will require companies to reserve against all gains at the current tax rate, whatever it may be.

In economic terms, the liability, equivalent to a transfer tax, resembles an interest-free loan from the U.S. Treasury that comes due only when the asset is sold.

Because of the way the tax law works, the Rip Van Winkle style of investing that Buffett favours, is much favourable than a short holding period of securities.

Suppose there is an investment that is bought at $1 and doubles in value. Each year, it is sold and the proceeds used to purchase another security which then doubles in value after another year.

At the end of 20 years, the 34% capital gains tax that is paid on the profits from each sale would have delivered about $13,000 to the government and $25,250 to the investor.

However, if there is a fantastic investment that itself doubled 20 times during the 20 years, its final value would grow to $1,048,576. If it were then sold, there would be a 34% tax of roughly $356,500 and the investor would be left with about $692,000.

The sole reason for this difference in results would be the timing of tax payments. Deferred taxaxtion is great!

Undistributed Earnings

In 1989 Berkshire recieved about $45 million, after taxes in dividends from their five major investees. However, their share of the retained earnings of these investees totaled about $212 million, not counting large capital gains realized by GEICO and Coca-Cola.

Are these undistributed earnings as important as those that were reported?

Buffett believes so. His reasoning is that earnings retained by these investees will be deployed by talented, owner-oriented managers who sometimes have better uses for these funds in their own businesses than in Berkshire.

Thus, a better gauge of Berkshire’s fundamental earning power is by using a “look-through” approach, in which the share of the operating earnings retained by Berkshire’s investees are appended to their own reported operating earnings, excluding capital gains in both instances.

Borsheim

There is a story related by Buffett about Ike Friedman. It has nothing to do with investments but it’s so humourous that I’m reproducing it below for your reading pleasure:

A story will illustrate why I enjoy Ike so much: Every two years I’m part of an informal group that gathers to have fun and explore a few subjects. Last September, meeting at Bishop’s Lodge in Santa Fe, we asked Ike, his wife Roz, and his son Alan to come by and educate us on jewels and the jewelry business.

Ike decided to dazzle the group, so he brought from Omaha about $20 million of particularly fancy merchandise. I was somewhat apprehensive – Bishop’s Lodge is no Fort Knox – and I mentioned my concern to Ike at our opening party the evening before his presentation. Ike took me aside. “See that safe?” he said. “This afternoon we changed the combination and now even the hotel management doesn’t know what it is.” I breathed easier. Ike went on: “See those two big fellows with guns on their hips? They’ll be guarding the safe all night.” I now was ready to rejoin the party. But Ike leaned closer: “And besides, Warren,” he confided, “the jewels aren’t in the safe.”

Buffett offers the following insights for the continued success of Borsheim and Nebraska Furniture Mart:

(1) unparalleled depth and breadth of merchandise at one location
(2) the lowest operating costs in the business
(3) the shrewdest of buying, made possible in part by the huge volumes purchased
(4) gross margins, and therefore prices, far below competitors
(5) friendly personalized service with family members on hand at all times

These are useful factors to consider when evaluating investments in retail businesses.